Dr. Frank Norton: Strategies for effectively using Roth IRAs

It’s Your Money

My prior column entitled "Making a good retirement deal even better" discussed why it would be advantageous for many to convert their traditional IRAs and dormant 401Ks into Roth IRAs. To recap:

n No required minimum distribution. You have control as to when the money is withdrawn.

n No income taxable withdrawal, even for heirs.

n Tax rates may be going up in the future. By having our IRA funds taxed now at potentially lower tax rates just might be a great idea.

n We can spread the tax hit over two years instead of having to pay tax on the conversion all at once. This benefit will be offered to us in 2010.

Assuming that it just might be beneficial for you to convert your IRAs into Roth IRAs, lets consider some strategies that might help that conversion to be as tax effective as possible.

n You don't have to convert all of your IRA funds into a Roth IRA at once or in the same year.

Even though we can spread the tax hit stemming from the conversion over two years once we hit 2010, it still might not be the best tax strategy.

We don't have to convert all of our IRA funds into Roth IRAs at the same time, either.

We can do it piece meal over a number of years.

The objective here is to try to keep within the same tax bracket as you would have been if you hadn't performed a Roth conversion. So take a look at how much additional taxable income you can add each year without pushing you into a higher tax bracket, then convert only that amount of IRA to Roth IRA.

You might get your favorite tax accountant to help you with this calculation.

n Consider putting converted IRA money into a new account rather than into an existing Roth account.

Why? You can always re-characterize the account back to a traditional IRA if you should find the account value plunge some more after conversion.

Then reconvert the lower valued IRA back to a Roth IRA, but with a lower tax impact than would have been the case with the original conversion (see IRS publication 590 for the timing details).

An extension of this thought is to open up a separate Roth for each type of investment you make with the converted money.

That way you can "cherry pick" the losers.

If the accounts were all under one account umbrella, the loss of one account would be diluted or offset by the gain in another - thus mitigating or eliminating this tax strategy.

n Holders of IRAs in variable annuities can convert these investments into Roth IRAs as well.

The current value of the underlying investments in their variable annuities has fallen below their income benefit. In this situation, if you convert to a Roth, you'd pay tax on the lower account value - and potentially get a higher benefit in the future tax-free.

n Is there a way to offset that additional taxable income, resulting from a IRA to Roth conversion, with tax deductions from some other source?

Yes there is. If you own a business, figure out ways of paying more deductible expenses in the current year instead of differing them to a future year.

Also, consider investing in an oil and gas drilling program where up to 90 percent of the investment can be taken as a current year tax deduction, thus offsetting the taxable income caused by the conversion.

In addition, you have the potential of getting good cash distributions back if the wells drilled are successful wells.

What should you do now to prepare for 2010 when you can spread the tax hit on the IRA conversions over two years instead of just one?

n If you have money to invest, consider funding an IRA before Dec 31. That way, you can convert those assets to a Roth as soon as Jan. 2, 2010.

n Locate and organize your paperwork for any nondeductible IRA contributions you've made in the past.

This would help you identify what portion of your traditional IRA funds will be taxable.

n Either look online or go to a qualified financial planner to then calculate net benefit of conversion year by year so that you will have accurate information upon which to make a decision.

So, if you just might find yourself sleeping better at night knowing that your retirement assets, once withdrawn, won't be touched by future higher tax increases, then start digging out your IRA records and do the number crunching.

You may be significant tax dollars ahead if you do.

D. Frank Norton is a money manager and financial planner in Santa Clarita. "It's Your Money" appears Thursdays and rotates between a handful of the Santa Clarita Valley's financial professionals. His column represents his own views and not necessarily those of The Signal.